Stumbling Blocks for Brazil’s Economic Recovery as Election Looms

Against all odds, the Brazilian economy is gradually recovering. Despite the country’s hapless regime, the enormous corruption scandal, and the substantial fiscal challenges ahead, Brazil has emerged from its worst-ever economic recession, responsible for a GDP per capita drop of more than 10 percent. Authorities and markets have been celebrating these recent trends, as they expect greater economic traction into 2018 will help elect a reformist president next October. The recent recovery and the auspicious tale for next year’s presidential elections should, however, be viewed with caution.

Following two consecutive quarters of positive growth, Brazil has technically exited recession. While such news is welcome, the uptick in GDP was largely driven by factors that are not self-sustaining—and that have little to do with the government’s reform agenda. The first quarter of 2017 benefited from modestly higher international commodity prices and a bumper crop that led to a boost in exports, as well as to declining food prices. The lower food prices, coupled with a cautious monetary stance—the Central Bank has been reducing interest rates at a modest pace for the past several months—resulted in a sharp drop in inflation. Brazilian consumer price index (CPI) inflation currently stands at about 2.5 percent on a 12-month basis, the lowest rate since inflation targeting was adopted in 1999. Rapidly falling inflation and wage indexation have been an auspicious combination: Since wages are adjusted by past inflation, and current inflation is much lower than past inflation, households have seen some real wage gains. Real wage increases coupled with the government’s decision to allow withdrawals from one of Brazil’s forced savings funds (FGTS) between March and July served to boost consumption in the second quarter, resulting in continued GDP expansion.

While the temporary allowance of withdrawals from the FGTS is no longer in place, inflationary trends are consistent with the Central Bank’s strategy of further monetary easing, which would provide some support for the economy going forward. That said, immense fiscal challenges remain, with fiscal deficits expected to continue well into the medium term and the risk that the debt-to-GDP ratio will hit 90 percent over the next two years. Moreover, as President Michel Temer’s reform agenda has stalled because of recent scandals affecting him directly, the prospects for pension reform are grim. Without pension reform, the expenditure cap approved in December of 2016 could be breached as soon as the next government is in place, in early 2019.

Although market participants fully recognize these risks, they have been willing to bet that by 2018 the recovery will be sufficiently strong to increase the chances that a reformist candidate will be elected. The assumption is that, despite President Temer’s dismal approval ratings, rising GDP, falling inflation, and the incipient labor market recovery that have recently characterized his administration will help elect a candidate who is sympathetic to Brazil’s ambitious economic reform agenda. The agenda includes an ambitious overhaul of the tax system; reform for the pension system, labor, and the financial sector; and deep cuts to government spending to rein in runaway deficits projected over the medium term.

Put differently, markets believe that a turnaround in the economy will erase political polarization and the risk of electing a far-right or left-wing “populist” in 2018. If the recent past is a reliable indicator, markets may yet turn out to be right: In 2014, while unemployment was falling and real wages rising, Dilma Rousseff was reelected for a second term, despite increasing signs that the economy was going awry.

Recent polls and opinion surveys, however, suggest otherwise. The Temer government has the highest rejection rate ever recorded—85 percent of Brazilians think his administration is “bad” or “terrible.” When asked about falling inflation, labor market stabilization, or signs of economic growth, many respondents echo the belief that these are the illegitimate results of government corruption. Amongst the top five issues that concern Brazilians, corruption is number 2, second only to the dismal provision of health services. Other issues high on the electorate’s priority list are public safety, education, and the creation of stable jobs—most of the recent decline in unemployment has been driven by a rise in informal jobs. When asked about the type of candidate they would like to vote for in 2018, Brazilians list “anti-establishment,” “someone who will bring back law and order,” “being an outsider,” and “being an agent of change.”

Meanwhile, reformist “center” candidates do not seem to excite Brazilians, either because they are political insiders, unappealing candidates, or seen as associated with the Temer government. Moreover, the reformist center is currently a crowded field, likely to become even more saturated as October 2018 approaches.

While markets double down on bets that the economic recovery will continue under a newly-elected government, polls strongly suggest that elections are no longer about the economy, echoing events elsewhere in the world. Put differently, “populism,” whether from the left or the right, is far from dead. Failure to recognize the real risk that an anti-establishment, anti-reform, “drain the swamp” candidate might be elected could lead to a rude awakening in early 2018. Hopes for political and economic stability could still be easily crushed.